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Some people want you to believe that the Fed just injected the economy and stock market full of money that will now result in an economic boom and much higher prices in most assets. That’s simply not true. Here’s the actual mechanics behind QE.

Before we begin, it’s important that investors understand exactly what “cash” is. “Cash” is simply a very liquid liability of the U.S. government. You can call it “cash”, Federal Reserve notes, whatever. But it is a liability of the U.S. government. Just like a 13 week treasury bill. What is the major distinction between “cash” and bills? Just the duration and amount of interest the two pay. Think of one like a checking account and the other like a savings account.

This is a crucial point that I think a lot of us are having trouble wrapping our heads around. In school we are taught that “cash” is its own unique asset class. But that’s not really true. “Cash” as it sits in your bank account is really just a very very liquid government liability. What is the difference between your checking and savings account? Do you classify them both as “cash”? Do you consider your savings accounts a slightly less liquid interest bearing form of the same thing a checking account is?

What is a treasury note account? It is a savings account with the government. So now you have to ask yourself why you think cash is so much different than a treasury note? What is the difference between your ETrade cash earning 0.1% and that t note earning 0.2%? NOTHING except the interest rate and the duration. You can’t use your 13 week bill to pay your taxes tomorrow, but that doesn’t mean it isn’t a slightly less liquid form of the exact same thing that we all refer to as “cash”. They are both govt liabilities and assets of yours.

When you own a t note you really just traded your “cash” for a slightly less liquid form of the same exact thing. If the Fed buys those t notes from you they give you back your cash minus the interest rate. That’s all there is to it. No change in the money supply. No change in anything except the rate of interest you were earning. If the government removes t notes then all they’re doing is altering the term structure of their liabilities. They’re not changing the AMOUNT of liabilities.

“Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed.”

This is very important because millions of investors are betting on the inflationary impact of QE. But again, as Mr. Bernanke said there is no reason to believe that QE is inflationary. Why? Because they are not adding net new financial assets to the private sector. The assets already existed! They are merely swapping reserves for bonds. They are giving the banks a checking account instead of a savings account. What does this mean? If Bank A owned a 1.2% 5 year note and they sell that note to the Fed they receive reserves earnings 0.25%. Their savings account was changed to a checking account. What changed? Nothing. Just the duration and rate of the paper. The number of assets in the system is the exact same. You can see this description in the following diagram (via Alea):

As you can see the net financial assets are UNCHANGED. They are merely changing the composition of the bank balance sheet. The logical question that most people ask is: “where did the Fed get the money to buy the bonds?” They didn’t get it from anywhere. It truly is ex nihilo. But it is not new money being injected into the private sector. It is merely being swapped with something that was already spent into existence. Therefore, you’ll often hear that banks have new money to put to work. That’s not true. They had a 0.2% piece of paper that was already put to work and can be exchanged in markets for whatever they please. There is not “more firepower” in the market following QE. All that the Fed altered was the duration of the U.S. government’s liabilities. The Fed took on an asset (treasurys) and also accounted for a new liability (the reserves). But this transaction did not change the net financial assets in the system.

The point here is that from an operational perspective the Fed is not really altering the money supply. There might be some slight market change in the bonds the Fed purchases, but this is offset by the fact that the private sector is losing interest income they would have otherwise earned. For instance, in QE1 the Fed removed $1.2T in assets from the private sector. Much of this was high yield paper. We know the Fed turned over ~$50B to the U.S. treasury (its “profits”) from QE1. What did the banks get in return? They got a checking account at the Fed earning 0.25% or roughly $2.5B over the course of QE1. So the private sector LOST ~$47.5B in interest income it would have otherwise earned.

So, now you must be asking yourself why the heck they’re even doing this to begin with. Well, QE supposedly changes the term structure of the bond market. Fewer 5 year notes should lower interest rates and entice borrowing, generate lending, make other assets more attractive, etc. If you sell your bonds to the Fed and receive low interest bearing cash you might want to rebalance your portfolio. Mr. Bernanke is hoping you will reach out on the risk curve and buy equities or corporate debt. But the price you purchase those securities at will depend entirely on their fundamentals and the price that you and the seller agree upon. If you run out and bid up risk assets just because you think the Fed is “printing money” then you’re making a mistake. If you run out and buy stocks even though their fundamentals have not changed you are making a mistake.

This is probably best seen in the price of commodities presently where investors are hyperventilating over the “printed money” and buying up hard assets. For instance, coffee prices are up 70% since QE started yet Howard Schultz, the CEO of Starbucks says the fundamentals have not changed at all in the last two months. He claims the speculators are to blame (thank you for that Ben Bernanke!). Inefficient market at work in real-time? Sure looks that way and we can thank the Fed for causing the bubbly situation in commodities. They’re advocating undue speculation, causing severe market distortions, driving down the dollar and rewarding speculators for further financializing this economy.

The Fed has caused this mass hysteria over a minor interest rate decline. In short, there is not more cash in the system following QE. There is not more “firepower” with which to purchase equities. Hopefully, the above description makes that very clear. This was most obvious in Japan where QE caused a brief 17% rally in equities as speculators leveraged up, jammed prices and then later realized that the slightly lower yields hadn’t really changed anything. What happened next? Their equity market fell 40%+ over the next two years. QE was a great big “non-event”. All it did was manipulate markets temporarily and cause a huge amount of confusion.